China's Economic Rebalancing Killed The Asian Locomotive

By: Andrew_McKillop

PEKIN SCHEMES, PEKIN DREAMS
As we know, if we believe what we read in the media, Edward Snowden might be trying to return home and face show trial, but “under his own conditions”. In any case Vladimir Putin will be glad to get rid of him the same way China's leadership very quickly passed the buck, or rather the Snowden hot potato to Putin. More important for the world economy, China is no longer playing Asian Locomotive and has radical new plans – due to the pressures causing the new plans – for steering its economy.

In the space of not much more than three months, culminating in last week's Chinese bank sector liquidity crunch which sent the cost of short-term loans to such giddy heights it roiled global markets, almost every financial institution and every major analyst have lowered their growth forecasts for China. The cutbacks are coming faster – and bigger. The World Bank's most recent forecast for 2013 Chinese growth was slashed by close to one percent, to an estimated 7.7 percent, but that is no longer a low-side estimate. Many banks and major players like Goldman Sachs have downgraded their China forecasts at an accelerating and deepening rate, making 7 percent the new high-end. Playing with the inflation rate also helps, because inflation in China is as segmented and variable from one sector to another, even inside the financial sector, as in major Western economies with the massive difference that in China, there is no trace of deflation – except when it concerns real asset values minus debt.

Why China's leadership would “want to slay growth” is not a question that can be asked in China. The leadership has a seamless wall of rhetoric and disinformation as an answer, propaganda as faultlessly false as that used by Ben Bernanke or Mario Draghi, but much more important, China has no choice but “rebalance” its economy.

CUT AND CUT AGAIN
All the present bank and institutional China growth forecasts are likely still too high. Nothing prevents China's economy doing what the Western economies did in 2008-2009, followed by most of them “recovering” to near-zero real growth for the years since 2010. China's economy, as its leadership says but using its own special coded language, is making a giant turning as it transforms from one based on export growth driven by export industry investment - to one driven by domestic spending and the reduction of debt.

Growth predictions are in fact rearview mirror images of China's former economy and can only underestimate the impact of this shift. They tell us about previous-only “trends continued”.

China's shadow banking system (SBS) as I noted in another recent article is massive, but at least as important as its uncontrolled and unregulated status, its size is also unknown. Some guesstimates suggest its SBS may marshal assets equal to about 50% of the formal banking system. The recent liquidity crunch, and the pressure which caused it, illustrates the difficulties China's economy will face in the future. Certainly since 2010, increasing all the time, major industrial corporations as well as finance-sector companies have operated as SBS entities to avoid central government controls, using foreign trade in any good, asset or instrument as the support for achieving their single goal of borrowing money from overseas lenders. This is often through offshore affiliates using fake trade invoices to import funds into China disguised as revenues from export sales of non-existent goods.

These funds are in priority used outside the industrial sector. The flood of mainly US dollars arising from fake exports, as well as dollar inflows from real exports, cannot be spent because they exceed Chinese spending on imported goods and Chinese overseas investment, with the direct result that the state's PBC central bank is forced to buy excess dollars to prevent the value of the renminbi or yuan going higher. Placing the surplus dollars as extreme low yielding US Treasury bonds while borrowing renminbi inside China at higher overnight rates results in ever-increasing losses for the PBC as its dollar reserves continually expand.

This has a number of negative impacts, including a huge increase in SBS lending activity and high rates of inflation outside the “official sector” as overall credit (dollars + renminbi) powers upward. Since May, the authorities have started clamping down on fake export invoices with an automatic decline in the apparent (but unreal) amount of exports made by China.  Foreign currency inflows into China have dried up, causing a liquidity crisis as the former rapid credit growth slows. How China manages this banking and monetary crisis remains to be seen – but the effects of this on distorted national accounts, showing massive but unreal exports, has already been major.

THEY CALL IT REBALANCING
The surprising thing about China's slowdown, called “rebalancing” is that it exists as a policy for at least three years, but has been applied in strange ways. What is happening is more insidious – the slowdown or “rebalancing” has applied itself.

Among the official rebalancing policy goals we find the intention to cut back on industrial investment and to reduce the role of corporate debt. The possible interpretation that increasing consumer credit – and therefore debt – is another goal can be rapidly discarded. This is light years away from the real situation, where the combined liquidity of the SBS and formal banking system taken together, is massive, but as shown by last weeks liquidity crisis, the overall system's ability to “turn on a dime” and run short of renminbi despite the vast amounts of “structural” liquidity, is a clear sign of instability.

At any time, inflation can explode.

Inside China, to the extent that policy speculation or criticism is permitted, some analysts say the administration of President Xi Jinping is hostage to the actions of it's predecessor, Hu Jintao, who engaged a policy of permanent expansion until very nearly the end of Hu's reign, While in public  President Xi promises he will stay the course, events like last week's liquidity crisis could cause his regime to take out the fire axe to pursue its growth-constraining “rebalancing” policy which includes a halt to credit expansion.

President Xi certainly knows the dangers of that strategy! Almost any previous Stars of Growth in the Chinese economy – real estate, cars, capital-intensive high-tech manufacturing – are experiencing serious debt or leverage problems and sometimes extreme difficulty adjusting to slower growth, while the bottomless pit of local and municipal government financing continues its craving for constant and rapid credit expansion. Halting this will certainly and surely mean a significant reduction in economic activity over the next decade.

WIDE-RANGING SPINOFF
US media reporting the Edward Snowden affair attempted to paint a picture of Putin's Russia crowing with evil pleasure at America's humiliation – while China's response was almost civilized. In fact Chinese media, all of it state controlled, has been harsher on the US, on the Snowden affair, than Russia's media which is only “regime friendly”.  China was polite but cold. It had no time at all for US whining. The emerging Chinese political attitude or stance to the rest of the world is that Pekin is playing a grave and difficult domestic game and if the rest of the world does not want to understand the stakes, or accommodate China's transition to a sustainable growth model, and for example starts playing hardball on trade relations – they will get massacred.

China is moving a lot faster than many persons realize. As policymakers in China continue to try to restructure the economy away from reliance on massive, debt-fueled investment projects which create little or no value for the economy, the rest of the world meaning the United States, Europe and Japan must understand that if they raise trade pressures at this time they can abort the difficult “rebalancing” which under any hypothesis can only, and will only reduce growth. As last week's small-sized but menacing banking crisis showed, the stability of China's economy especially as trade surpluses decline along with real foreign investment, is low. A trade war at this time may be devastating.

Just as certain, if China's economy tips into crisis driven by a monetary and banking crisis, this will also have devastating implications for global markets.

The Snowden affair and how China handled it – compared with Putin's Russia – provides us another window on how critical the “rebalancing” act has become in China, which has no time to play with “cyber spy” escapades with an American domestic political handle. Regardless of what happens next, talk about China's economy growing at around 7 or 8 percent over the next few years is unrealistic, even nonsensical.

As the reliable dummy for real economic growth in China – its coal burn and coal import data – will soon show, with a possible collapse of coal imports, the economy is slowing fast. Realistic analysts say that 3 or 4 percent growth is what we should expect but the number of open questions are as high as the closed doors for Edward Snowden. Adjusting to the end of the Asian Locomotive – which ran on coal - will be a tricky proposition but the real world policy of China, for years ahead, will be de-levering domestic debt, satisfying Chinese consumers and building a sustainable economy.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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